Chapter 3
Analyzing Bank Performance
Chapter Objectives
1. Introduce bank financial statements, including the basic balance sheet and income statement, and
discuss the interrelationship between them.
2. Provide a framework for analyzing bank performance over time and relative to peer banks.
Introduce key financial ratios that can be used to evaluate profitability and the different types of
risks faced by banks. Focus on the trade-o$ between bank profitability and risk.
3. Identify performance measures that differentiate between small, independent banks (specialty
banks) and larger banks that are part of multibank holding companies or financial holding
companies.
4. Distinguish between types of bank risk; credit, liquidity, interest rate, capital, operational, and
reputational.
5. Describe the nature of and meaning of regulatory CAMELS ratings for banks.
6. Provide applications of data analysis to sample banks’ financial information.
7. Describe performance characteristics of different-sized banks.
8. Describe how banks can manipulate financial information to ‘window-dress’ performance.
Key Concepts
1. Bank managers must balance banking risks and returns because there is a fundamental trade-o$
between profitability, liquidity, asset quality, market risk and solvency. Decisions that increase
banking risk must offer above average profits. The more liquid a bank is and the more equity capital
used to fund operations, the less profitable is a bank, ceteris paribus.
2. Banks face five basic types of risk in day-to-day operations: credit risk, liquidity risk, market risk,
operational risk, reputation risk, and operational risk. Market risk encompasses interest rate risk,
foreign exchange risk and price risk. Each type of risk refers to the potential variation in a bank’s net
income or market value of stockholders’ equity resulting from problems that affect that part of the
bank’s activities.
3. Banks also face risks in the areas o$-balance sheet activities, which create contingent liabilities.
4. A bank’s return on equity (ROE) can be decomposed in terms of the duPont system of financial ratio
analysis. This examination of historical balance sheet and income statement data enables an analyst
to evaluate the comparative strengths and weaknesses of performance over time and versus peer
banks. The Uniform Bank Performance Report (UBPR) data reAect the basic ratios from this return on
equity model.
5. Di$erent-sized commercial banks exhibit different operating characteristics and thus performance
measures. Small banks typically report a higher return on assets (ROA) than large banks because
they earn higher gross yields on assets and pay less interest on liabilities.
6. High performance banks generally benefit from lower interest and non-interest expense and limit
credit risk so that loan losses are relatively low. They also operate with above average stockholders’
equity.
7. Many banks can successfully “window-dress” performance by manipulating the reporting of financial
data. They may accelerate revenue recognition and defer expenses or selectively alter when they
take securities gains or losses and time when to charge o$ loans or report loans as non-performing.
As such, they may inappropriately smooth earnings with provisions for loan losses or by other
means. Analysts must be careful when evaluating extraordinary transactions that have one-time gain
or loss features.
Teaching Suggestions
It is extremely important that students fully understand the material in this chapter before aDempting
more diEcult analysis. The text introduces actual balance sheet and income statement data for PNC
Bank, the principal subsidiary of PNC Bank Corp., and data for a hypothetical community bank that is
representative of the typical independent bank. You should take a substantial amount of time to describe
the basic balance sheet items, emphasizing the dominant holdings of loans, securities, and cash/cash
equivalents among assets, and the role of core deposits versus noncore or purchased (hot money)
liabilities. Demonstrate how the income statement is structured to emphasize the financial nature of
banks by focusing on net interest income and the comparison on noninterest income and noninterest
expense. Contrast this with the income statement of a nonfinancial corporation. It is also useful to
discuss the role of provision for loan losses, its noncash expense feature, and the linkage with the
contra-asset account for loan loss reserves. Many banks view provisions as an easily managed figure that
can produce whatever earnings figure is desired.
The application of the return on equity (ROE) model to PNC’s data and the risk measures can be used to
demonstrate the trade-o$ between profitability and risk. Carefully walk students through the
calculations of ROE, ROA, EM, AU, ER and TAX, but focus on interpreting the ratios. AIer students
understand the calculations, review the data in Exhibit 3.8 and discuss the relationship of all the profit
measures to the overall profit performance of the bank. Do the same for the key risk measure in Exhibit
3.9. Note that more detailed information for PNC from the bank’s UBPR appears in the Appendix to
Chapter 3. These data and those in the Contemporary Issues: The Fall of Enron and Its Impact on PNC
Bank provide useful comparisons of PNC’s performance over time from 2000-2004 and versus peer
banks.
As an assignment, it is useful to have the students evaluate the profitability and risk ratios for
Community National Bank (CNB) and write-up an analysis to be discussed in class. This works best aIer
completing a detailed analysis of PNC’s data. It is easy to get bogged down in data. Students should be
encouraged to focus on interpreting the financial ratios rather than on the calculations. The template
provided with the text can be used to handle subsequent computations and cases. Emphasize the
importance of reviewing at least 3 years of historical financial data to determine key trends, and
comparing the most recent performance ratios with those of peer banks to determine where significant
deviations occur.
The financial ratios are provided in a framework that follows reporting in the Uniform Bank Performance
Report (UPBR), which bankers obtain from federal regulators. The BANK template provided with the text
can be used by students to evaluate the performance of any financial institution once students have
entered the raw data.
Special Projects
1. Select a community bank that has recently been in the news for problem loans (see the FDIC web
site at www.fdic.gov/bank/individual/failed/banklist.html for samples). Have students obtain the
most recent UBPR data for the bank from the FFIEC’s web site (www.Eec.gov/UBPR.htm). Assign
them to write a report critiquing the bank’s profitability and its ability to control operating costs
(versus operating income) and loan losses (net charge-o$s). Ask them to assess the adequacy of
the bank’s loan loss reserve. The exercise will demonstrate trends in bank performance over time
and the predictability (or lack-of predictability) of the data in forecasting future performance
diEculties.
2. Select two or more well-known nationwide or super regional banks and obtain their most recent
annual reports and 10-K statements, if possible. Require that students carefully review footnotes to
the financial statements for additional information and ask them to read the chairman’s leDer to
stockholders. Students should submit a wriDen report as if they are a consultant responsible for
identifying strengths and weaknesses in firm performance, and recommending strategic changes in
management policies to improve performance.